Stealing Money from Teachers in 3 Easy Steps: 401k/403b Plans
In general, the Grizzlies are a Huge fan of 401ks and various tax-advantaged accounts. There are many cool things that you can do with them – from building ROTH withdrawal ladders, to paying for medical care, to shielding large amounts of money from taxes. Overall, they are great tools that should be a part of any retirement plan and should be looked at a part of a holistic approach allocating your assets.
However, not all is rainbows and unicorns in the land of tax-advantaged savings vehicles. I was personally confronted with this sad fact last month. My Mother is an elementary school teacher. She’s been the librarian at a public school in Kansas for the last 30+ years. I’d like to say she’s pretty damn good at her job, much better than the librarians I ever had at my schools growing up. She was an active and engaged part of the student’s lives – doing everything from running awesome programs to expose kids to award-winning books to campaigning for changes to the Kansas State funding structure for public schools. She did her job well for many years and retired this last spring. She has a decent pension, social security, and a small amount saved in a 403b plan.
A 403b plan is the public sector equivalent of the 401k plan most people are familiar with. It’s the savings vehicle that has largely replaced defined benefit pensions in the US over the last few decades. I’ve covered exactly how 401k/403b plans work in past posts. But the basics are pretty simple. Your employer sets up a plan with a financial services firm with a bunch of different options. You elect a certain amount to be deducted from your paycheck every month. Your contributions can either be pre-tax or Roth. If pretax you don’t pay taxes on those funds when you deposit but will when you eventually withdraw. If Roth you pay taxes on those contributions now but everything will be tax-free forever. easy peasy lemon squeezy. A great way to save on your tax bill.
The part where big firms start stealing money from teachers (and many others!) comes in here – “Your employer sets up a plan with a financial services firm with a bunch of different options.”
I’ve helped her with investments over the years and always noted the poor quality of the plan. But a recent exchange with her 403b plan provider was the last straw. The plan provided by her employer amounts to a fleecing of a ton of hardworking teachers and their families. Here are the three easy steps her plan followed to steal a huge amount over the years. Steps that many other 401k providers love to use!
Step 1: High Fees
I’ve talked a lot about the benefits of index funds, but the biggest single benefit is the low fees associated with them. Many 401k plans are absolutely packed with crap funds charging high fees that don’t deliver any better returns than a simple SP500 or total bond market index fund. The 403b plan from my mother’s school district was a perfect example. The average fee’s charged annually across all of the available investment options was a whopping 1.2%. The lowest is 1%. Compare this to the current average fees on the Grizzly’s mix of low-cost index funds of about 0.07%. On average the accounts in these plans were losing over 1% percent of return per year. And getting nothing for it. Looking through the options I eventually found one plan that had actually managed to beat its index. One. Over a typical 40 year career this amount to hundreds of thousands of dollars lost to banks and investment managers who contribute almost nothing.
Hundreds of thousands of dollars that could have been in the pockets of hard-working investors diligently saving for their retirement. The only thing standing in their way was the crappy investment options provided by their employer.
Step 2: Confusing Options
The grizzly portfolio is made up of five index funds. Someone who really wants to simplify can get it down to two and get 90% of the real diversification – a stock index fund and a bond index fund. That’s all you really need. Most 401k plans are a morass of confusion options with awesome names like American Century Heritage or the Dryfus Appreciation fund. What’s actually in these two funds? Who knows! You have to read tiny fine print in a confusing prospectus to even get a hint. An average investor with little experience would be completely lost when looking at this for the first time.
To make matters worse the default arrangement of investment options as presented to customers seems somewhat insidious on most of these plans. The “research investments” screen that pops up on the school district plan conveniently seems to have the highest fee options located at the top. An inexperienced investor might easily think these are the ‘best’ options.
Step 3: Redemption Penalties
I’ve known about the other problems for a long time. Those are present in many 401k plans. But the final straw that prompted this post was something we came to discover just a few days ago. In addition to the problems highlighted above, the plan for my mother’s school district has a nice little surprise waiting for you at the end. A conversion penalty on any amount in the account for less than a certain number of years. Even after she retires she’s unable to pull her money out of these crappy options without forfeiting a large percentage of it.
These sorts of fees are actually quite common in the 401k business. High-cost financial institutions have very few other ways to compete with the likes of Vanguard.
Variation in Plan Quality is HUGE
One of the worst parts about all of this is that the above problems are not in every 401k plan. It is a random chance if you end up at a company with a fantastic 401k plan with dirt cheap, fantastic options. A plan that allows the whole host of after-tax contributions, in-service withdrawals, etc. I had such a plan at my tech company job in SF. Some folks end up with fantastic plans, some folks end up with plans that steal hundreds of thousands of dollars from their pockets.
The truly unfortunate thing is that I suspect that the people who can least afford it – the teachers, emergency service personnel, blue-collar workers – are by and large saddled with terrible plans. While the tech workers of the world making six-figure salaries like Grizzly Dad tend to have exceptional plans with great options. This is the trend I have seen when helping folks with their investments.
Still worth it, Unfortunately
Despite all of these problems, the tax advantages of 401k/403b plans still make them worthwhile. You’re better off putting money into a terrible 401k plan than not. If your 401k plan is truly awful then you should first max out IRA contributions first, but the 401k always comes next.
This is perhaps the most insidious thing about the 401k system. Because of the way the tax code is structured, a ton of financial institutions get to make large sums of money off of a bunch of captured customers who have no other choice.
Washington could, with the stroke of a pen, solve many of these problems. Instead of having separate buckets for 401ks and IRAs, enable EVERYONE to contribute a flat amount to tax-advantaged retirement accounts every year regardless of how they are administered. Have two types of plans, pre-tax and Roth. Set the caps at the current max 401k contribution ($18k pretax, $36k in Roth). Allow people to have a choice. Allow them to get out of the terrible plans run by their employers and terrible financial institutions. This would create a far simpler, easier system for most Americans. Sadly I don’t see anyone fighting for this in the current tax debate.
What can you do?
If you find yourself with a terrible 401k/403b plan what can you do? The first and simplest step is to find the lest terrible options. These are generally the options with the lowest fees that still enable you to maintain your overall allocation between stocks and bond. Find the cheapest funds and you’ll generally have found the best option. There is no evidence that shows high fees buy you anything in mutual funds.
Second, bang down HR’s door with as many friends as you can gather. Ultimately, the plan your employer chooses is a management decision. If enough angry employees make enough of a stink you can get things changed. Would you be angry if your employer ‘forgot’ to pay you for a month? Yes. You should be equally (or more!) angry if your employer sets you up in a 401k that eats away hundreds of thousands of dollars from your retirement.